Don't Be Too Leery of the Washington Squabbles

Stocks have risen 1.5% since Jan. 2, when Congress passed the underwhelming American Taxpayer Relief Act to avoid the fiscal cliff. That climb came despite an impending trio of late-winter fiscal policy challenges that might prove even more threatening than the cliff. As discussed in ubiquitous news reports and my own "Groundhog Day" warnings, the new troubles have surfaced thanks to lawmakers' failure to cut spending, extend the debt ceiling, or delay the $100 billion fiscal 2013 budget sequester for more than two months.

I refer to the Washington minefield ahead as "DC2." After all, it could prompt scary feelings of déjà vu, given its potentially most lethal charge -- the need to extend the $16.4 trillion debt ceiling by late February. The issue has already invited comparisons to August 2011, when President Obama and Hill Republicans last skirmished over the federal borrowing limit. That coincided with a sharp drop in market confidence, as well as an unprecedented U.S. debt downgrade by Standard & Poor's.

Meanwhile, if Washington doesn't take action, across-the-board spending cuts in defense and discretionary will kick in by March 1, and the government-funding continuing resolution (CR) is set to expire March 27.

As weapons of wealth destruction go, preventing a debt-ceiling hike is a truly nuclear tool that could threaten U.S. default. The sequestration is a meat ax lever toward federal funding cuts, and the expiring CR carries a threat of government shutdown. Yes, the latter two could obviously prove disruptive to individual companies and sectors, as well as potentially roil municipal-bond investors. But the threat of a U.S. debt default would seem far more worrisome.

However, a serious brush with debt default seems by far the least likely outcome. Also -- you heard it here -- sooner rather than later, Hill Republicans may signal their intention to be less obstructive than expected.

The Coming D.C. Dance

As House Republicans huddle for their annual retreat this week, they are wary of being blamed for any negative market or economic fallout from a face-off over the debt ceiling. They're also doubtful as to how effective a hard line might be in forcing the Democrats to accept spending cuts.

As a result, their leaders may already be vetting a surprising strategy: Engage in a good fight to try to force entitlement cuts in exchange for lifting the debt ceiling -- but also signal, early on, the party's unwillingness to force default. This would acknowledge, up front, the likely final result of any related fight -- i.e., the extension of the limit with primarily Democratic votes, as we saw with the cliff fix. Instead, as brilliantly argued by Keith Hennessey (former head of the National Economic Council), the GOP could use this ultimate safety valveto their advantage, agreeing if necessary to a series of only-short-term extensions, thus forcing Democrats to "own" future runaway spending.

Meanwhile, any bloodlust among House conservatives could still be sated via fights over the sequestration and CR, with the latter perhaps set to trigger the first government shutdowns since the Clinton era.

At any time along the way, this could gradually pressure President Obama and the Senate majority to agree to long-term spending reforms -- though Republicans would have to demonstrate unity and ability to hold their lines, which has been rare of late. Optimistically, this could yield a six-month, one-year ($1 trillion), or even two-year deal, although the last option continues to seem unlikely. That's because this would require mandatory spending cuts and serious Medicare-Medicaid reforms, as well as higher tax revenue -- and the latter may only be possible under the cover of tax reform that now seems unlikely.

In any event, should the GOP engage in this strategy of proactively preclude default, I see it providing even more oxygen to the fledgling first-quarter stock-market rally. Momentum here seems fed by hopes of improving global economic prospects, better earnings stories and rising equity fund inflows -- perhaps after an initial boost that came as we avoided "the latest Apocalypse Now scenarios," as my friend Dr. Ed Yardeni has described.

This should preclude a near-term negative response from rating agencies Moody's and Fitch. But, by the second quarter, we could see further pressure from dysfunctional shutdowns and a continuing lack of agreement to a serious deficit-reduction approach. This may or may not ultimately yield a mini-grand bargain, perhaps even to include additional new tax revenue.

For this reason, I'd be wary of forecasting risk ahead, as the range of possible outcomes is more likely skewed to the upside than it is to further losses. That, in turn, reinforces the view that investors shouldn't seek to trade the coming "DC2" risk story. If they do, they might miss some of the best gains of the year.